Credit Skills Library

Lending
Techniques
Credit Skills Library

Published by
The Chartered Institute of Bankers in Scotland
Drumsheugh House
38b Drumsheugh Gardens
Edinburgh EH3 7SW

Senior authors: Keith Checkley FCIB, FCIBS, Chartered Banker and Keith Dickinson FCIB
Editing and layout by Keystone Business Associates, Glasgow
The authors have taken all reasonable measures to ensure the accuracy of the information
contained in this topic and cannot accept responsibility or liability for errors or omissions
from any information given or for any consequences arising.

© Keith Checkley & Associates, March 2010

No part of this publication may be reproduced, stored in a retrieval system or transmitted
in any form or by any means – electronic, electrostatic, magnetic tape, mechanical,
photocopying, recording or otherwise, without permission in writing from The Chartered
Institute of Bankers in Scotland.

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 Lending Techniques

Lending Techniques

Key learning outcomes 5

Introduction 6
A business plan checklist 6
Aide-mémoire approach to lending 7
Key assessment areas 9
Essential requirements 9
Technical ability of the customer 10
Integrity of proprietors 10
Availability of business resources 10
Financial performance 11
Bank records 11
Annual audited accounts evaluation 11
Understanding the figures 11
Interpretation of the figures 12
The importance of the audited accounts 13
Financial statements analysis 14
Profit and Loss Account 14
Balance Sheet 16
Analysing the information 21
What we can get from audited accounts 21
What audited accounts do not tell us 22
Balance Sheets – creative accounting (“window dressing”) 24
Glossary of frequently used terminology 26
Review 28

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Credit Skills Library

Welcome to the Credit Skills Library

There have been previous financial crises but this time it is the severity
and global impacts that are very different from what we have seen before.
Never have banks and lending bankers received greater criticism over the
quality of their lending than at the present time.

Media comment suggests that prudent lending principles have been

disregarded in the quest in recent years for increased lending volumes
and enhanced short term profitability. Analysts suggest that many of the
prudential canons of lending have been overlooked and many lending
bankers would benefit from a reconsideration and review of well tested
and accredited lending principles. It is against this background that the
Credit Skills Library has been developed.

The modules in this Library have been prepared to allow you and your
colleagues instant access via e-learning and may be accessed as individual
topics in which you are interested. We believe that they will also make an
excellent basis for discussion with colleagues for mutual benefit.

We do hope that the extensive range will help you in your everyday job
and also as someone interested in self development in the important area
of Credit Skills.
Keith Checkley and Keith Dickinson
Senior authors
Working with The Chartered Institute of Bankers In Scotland

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 Lending Techniques

Lending Techniques

Key learning outcomes

■ Be aware of general lending considerations.

■ Understand a structured approach to risk assessment in business lending.

■ Be aware of the more popular mnemonics of lending.

■ Understand the basic component parts of financial statements.

■ Know the basic terms used in business lending considerations.

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Introduction

When we agree to lend money to a business, be it large or small, we do so on the basis that we will
get our money back on an agreed future date. To reach a decision to lend we have to make a
prediction of the likely future trading performance of the business and its ability to repay borrowed
monies at a future date in time. As we are unable to predict the future with any certainty, it is
difficult to make any lending which is totally free from risk. What we can do is endeavour to
minimise the risk involved by a logical assessment of the available and requested information
and then evaluating it correctly. We will consider logical approaches to the analysis of lending
opportunities and also some of the lending mnemonics that are popular with bank lenders.

Many lendings fail because of inadequate assessment, sometimes because we feel pressured
by customers into reaching rapid decisions. Before we begin to consider lending opportunities,
here are some general thoughts:

■ Always try to obtain the relative financial information in advance of a meeting, in order that
you may consider the questions you intend to ask. You cannot analyse financial information
during the course of an interview. Usually this will be presented in the form of a Business
Plan. Sometimes smaller business customers will feel unable to provide the information in
this form.

■ Do not accept the customer’s statements at face value. Seek confirmation and clarification
where appropriate.

■ Do not make assumptions or fill in gaps yourself. It is the customer’s responsibility to provide
all the relative information you require.

■ Do be sure that you fully understand the risk involved with the proposition before drawing
a conclusion and stating your decision.

■ If you are still in doubt, discuss the proposal with a more experienced colleague.

■ Distinguish between fact, estimates and opinions when reaching a decision. That decision
will be based on an appraisal of the financial and non-financial information that the customer
provides.

■ Ideally the customer should provide the information in the form of a Business Plan which
will address some of the following areas of the business.

A business plan checklist

OBJECTIVES What are the customer’s personal objectives?

What are the customer’s business objectives?
Are they specific?
Have they thought out the consequences?

THE BUSINESS History if already established

Accounts for previous years’ trading
Present financial position

MANAGEMENT Experience of proprietors/managers

Responsibilities of managers
Is the team complete or is further recruitment necessary?

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MARKET How large is it?

Is market research possible?
What is the competition?
What is the competitive advantage?
What advantages do competitors have?
What are the distribution channels?

PRODUCTS Do they meet customer needs?

Have they been tested including production methods?
How have costs been calculated?

PRICING How have prices been arrived at?

What are the gross margins?

SUPPLIERS Are adequate supplies available?

Is quality known to be acceptable?
What credit is available?

PHYSICAL RESOURCES What premises are available?

Are they adequate?
What is the cost?
What machinery/vehicles are required?
What is the cost?
How are they to be financed?

PERSONNEL How many will be needed?

What training will be required?

PROFIT AND CASH FORECASTS Are they available?

Are the assumptions valid and clearly stated?
What are the risks?
Can the business survive if it sells 20/40% less than
planned?

OUTSIDE FINANCE REQUIRED
What does the business need: for fixed assets?
for working capital?
For how long is the money required?
What is the programme for repayment?
Have a monthly cash plan been produced for the first
year?
What cash projections are there after the first year?

Aide-mémoire approach to lending

In lending appraisal it is very useful to use some form of aide-mémoire. Popular mnemonics
include:

CCCPARTS C Character
C Capability
C Capital
P Purpose
A Amount
R Repayment
T Terms
S Security/Collateral

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PEST Analysis P Political

E Economic
S Social/Regulatory
T Technical

PARSER P Person
A Amount
R Repayment
S Security/Collateral
E Expediency
R Remuneration

CAMPARI

CHARACTER Integrity and honesty

Stability factors
Financial track record
Resources
Ability to repay if things go wrong
Liabilities
Assets
Age
Health

ABILITY Earnings and prospects

Professional qualifications and experience
Business track record

MARGIN Interest rate

Commission
Fees

PURPOSE Reason for request

Appropriateness of request

AMOUNT Reasonable and correct in terms of purpose?

What percentage will customer contribute?

REPAYMENT Source: analyse income, expenditure (and projections)

Other sources of repayment available?

INSURANCE Is security necessary?

What is offered/available?
Complete the security before making funds available

The use of a mnemonic ensures that many of the relative areas of a proposition are covered
during interviews.

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Key assessment areas

In taking a more structured approach to lending, we can focus on the following key areas for risk
assessment:

• the customer and the business

• asset cover for the advance (and security)

• repayment ability/serviceability of debt

• monitoring of performance.

These areas are shown below. The pitfalls of lending to the applicant are usually when little
regard has been given to the business, its net worth or serviceability; or lending to the applicant
plus securing the debt, but with little regard to serviceability! If any of the key areas is ignored,
problems will be encountered sooner or later. A full assessment must be made to reach a balanced
judgement.

Key Assessment Areas

THE CUSTOMER

THE BUSINESS

ASSET COVER
▼

SECURITY

NET WORTH Monitoring

REPAYMENT PLANS
▼

SERVICEABILITY

It is vitally important to remember that a business, no matter how strong its balance sheet,
cannot carry a debt burden greater than can be serviced by the income-earning capacity of the
business. It is for this reason that great emphasis will be placed on understanding the trading
“profile” of the business. This is displayed in the trading and profit and loss account and is
projected in the profit budget.

Essential requirements

The five basic points that need to be considered for any type of bank lending are:

• How much is required?

• What is to be done with the money?

• What are the plans for repayment?

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• What will be the bank’s position if the plans for repayment go wrong?

• What is the experience and track record of the borrower?

In exploring these points, the following will help:

• The cash flow forecast will tell us what is to be done with the money and how much is
required.

• The plans for repayment will be illustrated in the cash flow forecast and the feasibility of
any repayments will be shown by looking at any margin available in the profit together
with the record of past profits in the audited accounts.

• If things go wrong, then the “buffer” or net worth is illustrated in the past audited accounts.

Technical ability of the customer

A key feature of the analysis of any lending proposition is the technical ability of the customer:
can he/she perform the tasks required to make enough money for successful repayment? For
example, can mechanics repair cars effectively, can plumbers install central heating appliances
without having leaks, can builders lay bricks to the standards required by the surveyors from the
local authority or the building society? There will be no source of repayment if the applicant does
not have the skills to satisfy reasonable customers – they will simply refuse to pay.

Integrity of proprietors

A checklist approach will be helpful:

• How long has the borrower been known? What is the borrower’s track record?

• If not known to the lender before, why is the borrower making the approach?

• Can evidence be shown of an acceptable track record elsewhere?

• Does the borrower have any business experience, especially in the area which is the subject
of the borrowing request?

• What is the borrower worth financially and how has personal worth been accumulated?

• What is the borrower’s personal commitment to the business? Is a personal guarantee being
offered where the borrowing will be by a limited company?

• Does the borrower have adequate life and health cover?

Availability of business resources

Visiting the business, particularly when a small enterprise, will be essential and will yield a lot of
information. Most people are receptive and only too willing to show you around. Observation
and discussion will enable you to make a judgement as to technical and management ability.

• What is the customer’s experience?

• How long has he/she been in business?

• Does he/she use modern techniques?

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• Is he/she in full control or spend a lot of time away?

• What is his/her depth of management ability and who is there to help?

• Does he/she delegate routine tasks?

• Who keeps the business records?

Also, you will see the business size and learn about the products, the state of the buildings and
machinery. Does the place look well organised? Have the buildings and machinery the capacity
to meet production plans? Look at any business plans and discuss them.

Financial performance

Historical annual accounts should be available to be analysed for all businesses except new
ventures. However, the standard of accounts can vary widely. The important thing which a lender
wishes to establish is the true financial position of the business and its real cash generating capacity
to cover debt repayment.

Bank records

Examination of the bank statements will reveal:

• business turnover

• average bank balance

• range of the account

• standing orders and direct debits and any unpaid cheques.

Comparison of these statistics with previous years will help paint the financial picture, for
example, falling turnover coupled with an increasing debit balance will merit close investigation!
This could indicate early warning signals of business downturn in performance.

Annual audited accounts evaluation

The accounts could well be historic but are well worth analysing. Most banks have forms for
extracting ratios. What we are looking for is a “reasonable” balance between net worth and debt;
other ratios will give us indications of liquidity, debt serviceability and trading performance.

Understanding the figures

To whom will we be lending? The principal forms of businesses that we meet most frequently are:

• sole traders

• partnerships

• private limited companies

• public limited companies.

The particular features of these business forms are summarised on the next page.

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Features Sole Trader Partnership Limited Company

Ownership Owned by a Owned by two Owned by share-

single person or more people. holders. Must have
No more than 20 at least two
partners (except shareholders.
for most types
of professional
partnerships.

Income Taken in the form Taken in the form Receive a salary from
of drawings from of salary and/or the company and
net profit. drawings from dividends when these
net profit. are declared.

Taxation Profits subject to Partner’ share of Company profits

income tax (including profits and/or salary subject to corporation
any salary paid). subject to income tax. tax. Shareholder is
subject to income tax
on remuneration
from company (if
director or employee
and dividends.

Interpretation of the figures

The most important areas to consider when lending money to businesses should probably include:

• Quality of the management

• Profitability

• Liquidity

• Gearing

• Interest cover

• Safety

■ Quality of the management

It is difficult to place too much emphasis on this aspect of a business. The success of a business
(and the lender) are very much in the hands of the management team.

The areas that should be considered about the management team are:
• Ages – background and health?
• Expertise – sales, production, financial?
• Well balanced or weak in some areas?
• Shareholdings/responsibilities?
• Track record?
• Succession?
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■ Profitability

Is the business capable of generating profits? Where will they come from?

■ Liquidity

What are the cash flow implications? How will the money flow in and out of the business?

Liquidity is the lifeblood of a business. The liquid position is important because it indicates
whether liabilities could be met without recourse to the fixed assets of the business. The collapse
of a business occurs primarily because it has run out of cash.

■ Gearing

Comparing the proprietors’ stake in the business with the amount of money borrowed. This
may be calculated on a gross basis or a net basis:

• Gross basis – compares the total borrowed from outsiders with the amount that the
proprietors are providing to finance the business. An increasing trend would highlight
greater reliance on outsiders. When calculating gross gearing, include all borrowing, short
term and long term (including directors’ loan monies), but not trade creditors or taxation.

• Net basis (Net of Cash held and Quoted Investments) – may be a more realistic view of
gearing.

■ Interest cover

The number of times that pre-tax, pre-interest profit covers the interest charged. It provides an
indication of the margin of safety before profits fail to cover interest charges. The higher the
figure the better. It should be not less than two.

■ Interest cover (cash flow basis)

As interest is paid out of cash rather than profits, it may be more relevant to consider how
successful the business has been in generating sufficient cash surpluses to cover its interest
payments.

■ Safety

How safe would the advance be if the business encountered problems?

The importance of the audited accounts

When assessing any business lending proposition, one of the most important pieces of information
available to a banker is the customer’s audited accounts. The financial statements of the differing
businesses will vary in detail enormously; from the small contractor filing self assessment figures
of sales and net profit to the rigorous disclosure requirements of a publicly quoted company.
We must be aware that these figures have limitations, namely:
• they are only a snapshot of one day in a year
• it is possible to manipulate the figures to show a distorted position, known as “window
dressing”
• when received, the figures will be out of date.
Having said this, the audited accounts are usually the best source of financial information
available, giving a clear indication of a customer’s past trading record.

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These figures, together with up-to-date management accounts, projections for the future, our
knowledge of the business and the run of the bank account should enable the relative and relevant
questions to be asked, with a view to quantifying future borrowing requirements. Past
performance will not necessarily be a guide to the future, but the information that can be obtained
from historical accounts provides a good starting point for assessing trends and future plans.

Bank lenders usually extract the figures shown in audited accounts onto standardised spread
sheets, allowing the trends revealed by several years’ figures to be compared. The value of any
individual year is limited and ideally, no one year should be looked at in isolation. Analysis
involves examining the relationship between groups of figures and trends from one year to the
next. A minimum of three years’ accounts should be analysed, if available.

Financial statements analysis

Profit and Loss Account

The Profit and Loss Account reports primarily the profits earned (or losses suffered) from normal
operating activities; it also reports gains or losses in transactions which are not part of normal
operations. All figures are accruals and do not reflect actual cash movements.

• Are profits being made and are these increasing in line with turnover?

• Are the profits from trading? This is preferable to profits generated by extraordinary
activities, for example profit on sale of fixed assets.

• Are they being retained in the business? We would not expect all profits to be paid away in
the form of drawings or dividends.

■ Sales

The main source of income for a business is its sales. Sales has two components – price and
volume – and therefore the total sales figures may be increased either by an increased volume
of goods sold, prices charged, or both. The ability to change one or both of these elements will
depend on the demand for product(s) and competitive position. We would only expect to see
a downward trend as a result of some form of rationalisation, otherwise it may indicate an
inability to sell the product or service.

■ Cost of Goods Sold (COGS)

Reflects the costs associated with those goods sold during the period in question, for example
costs of material. The stock valuation method that the company adopts will have some influence
on this figure. A comparison of profit performance between two businesses may be distorted
where these businesses use different methods. Over purchasing will be reflected in increased
stock levels and a deteriorating stock turnover period.

■ Gross Profit

Gross profit is calculated by deducting COGS from sales. Gross profit alone is of limited value
unless we compare it year by year to the sales figures.

■ Gross Profit Margin

This allows us to consider the profitability being generated from sales. A declining gross profit
margin may be one of the first signs of problems.

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■ Depreciation

Depreciation is a charge made in the profit and loss account recognising the fact that fixed
assets decrease in value and are “used up” over a period of time. It is an accrued or non-cash
charge. The Companies Acts require that the amount of depreciation, and the method of
calculation of depreciation, be disclosed by a company. In normal circumstances the level of
depreciation should vary proportionally with fixed assets.

Different calculation methods may be adopted, the most common being:

• straight line/fixed instalment method

If a machine has a value of £10,000 and an anticipated life of 5 years, the depreciation charge
would be 20% or £2,000 per annum in each of the 5 years it is owned by the business.

• declining/reducing balance method

The percentage charged depends upon the expected useful life of the asset but the expense
or charge is heavily weighted in the earlier years; for example, a machine worth £10,000
depreciated at 40% per annum would have a charge of £4,000 in Year 1, 40% of the balance
of £6,000 or £2,400 in Year 2, etc.

A business may change its method of depreciation where this will more fairly represent the
financial position, but the effect of the change must be disclosed in the annual report and
accounts.

■ Directors’ Remuneration/Drawings

Is this reasonable or are excessive amounts of remuneration being taken from the business? If
excessive, future trading may be affected.

■ Distribution Expenses/General and Administrative Expenses

Refers to those costs not directly attributable to the cost of the goods sold but incurred by the
business in its sales effort and general administration, for example indirect overheads,
advertising.

■ Operating Profit

Sometimes also referred to as trading profit, this gives the normalised profit of the company
before financing costs.

■ Interest Expenses

The costs incurred by the business in borrowing money over the period (principal repayments
are not included within the income statement). This figure is sometimes not shown in the
P & L itself but can be found in the notes to the accounts.

■ Interest Income

The interest paid to the business on its deposits over the period.

■ Exceptional Items

Any exceptional item which is abnormally large and unusual which would distort the operating
profit is shown here. It would be incurred in the normal trading of the business, for example a
large one-off provision for bad debts.

■ Profit Before Tax

The profits before deduction of tax liability.

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■ Taxation

The total amount of taxation being charged against the company’s profits during the trading
period in question.

■ Net Profit After Tax (Companies)

The profit available to shareholders before extraordinary items and dividends.

■ Extraordinary Items

Any income, charge, profit or loss that is significant in size (ie material) but is derived from
event or transactions outside the company’s normal activities. Typical examples are profits
from one-off sales of fixed assets or redundancy costs.

■ Dividends

The amount of money that is to be paid out to shareholders.

■ Net Profit

This is the net figure after deduction of all expenses and running costs.

■ Net Profit Margin

Represents the premium gained by the company for its products over the cost of production.
By comparing the trend of this margin and the gross profit margin we can ascertain how closely
the business is controlling its overhead costs.

Balance Sheet

■ Current Assets

Those assets that are expected to be converted into cash within a year.

■ Cash

Is this available immediately? Compare with previous years. Any substantial difference should
be examined to ascertain what has been done with the money.

■ Short term investments

Where investments are quoted on an established stock exchange they may be valued easily
and should be saleable. They are therefore liquid but nonetheless can drop in value. What is
the current value? Any difference between current market value and Balance Sheet value will
have an effect on the net worth of the business.

■ Trade Debtors/Accounts Receivable

This is the amount a business is owed by customers to whom it has sold on credit terms.

• Are they collectable?

• Are they well spread? The danger of a dominating debtor is that, should they fail, they may
precipitate the collapse of our customer.

• Does the customer collect debts efficiently? Are there any bad debts? Should debts become
doubtful or irrecoverable, adequate provision should be made.

• Consideration should therefore be given to the bad debt policy – what level of debt
historically have they had to write off? Is this level conservative or overoptimistic?

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• What are the terms of trade? What is the average length of credit given?

• Can the business provide an aged schedule of debtors?

■ Stock/Inventory

Valued in the Balance sheet at the lower of cost or net realisable value (NRV). If the NRV or
best price obtainable in the market is below cost, it must be written down and the loss taken in
the P & L account.

Stock is often broken down to:

• Raw Materials – risks to consider relate to the reliability of supply and variability of price.
Consider also whether any stock is subject to reservations as to title by the supplier until
they are paid for.

• Work in Progress – is the amount of material tied up in manufacturing within the production
process.

• Finished Goods – a high level of finished goods may indicate stocking up for high seasonal
sales, or that the company has a high level of obsolete stock.

Often the figures for the audit are provided by the proprietors/directors.

Example
Calculation of gross profit

ABC Company Ltd

12 month Trading Period ended 31 December 20XX
£ £
Sales 225,000
Less
Cost of Goods Sold
Opening Stock 1 January 20XX 81,500
Add
Purchases in Year 135,000
Sub-Total 216,500
Less
Closing Stock at 31 December 20XX 85,000
(valued by the Directors)
Total Cost of Goods Sold 131,500 131,500

Gross Profit 93,500

Gross Profit % 41.5%

If the closing stock is undervalued, this will understate gross profit, net profit and ultimately
the net worth of the business. Conversely, if a customer wishes to show a better position, by
overvaluing stock, this will increase both gross and net profit figures and the net Worth.

An expanding business will have a need for additional stock levels. Stock should be compared
with turnover and a rate of stock turnover calculated.

An increase in the number of days could indicate:

• out-of-date or unsaleable stock being held

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• falling sales

• stock being built up for a large contract

• special purchase of stock made at an advantageous price

• special purchase of stock prior to a price increase

• special purchase of stock prior to a peak sales period, such as Bonfire Night, Christmas.

A decrease in the number of days could indicate:

• high demand for the product

• the business is deliberately running down stock levels, for example change of fashion trend

• unavailability of stock.

The rate of frequency of stock turnover will depend on the type of business. Any substantial
change in the stock turnover rate should be examined.

■ Prepaid Expenses

Payment in advance. Whilst normally shown as a current asset in the case of a going concern,
these items will usually be irrecoverable in the event of liquidation or winding up, for example
rates, rent.

■ Fixed Assets

Fixed assets are those assets held permanently in the business that facilitate production or
operation but are usually not for resale, that is, it is generally not the company’s intention to convert
them into cash but rather to replace them on a continuing basis when they are worn out.

• Land and Building – Balance Sheet value will be original cost less depreciation.
Are the premises adequate for the business as regards size and location? Does the figure
shown disguise a hidden reserve? (ie Balance Sheet value £50,000, realistic current market
value £100,000). A revaluation of assets can be made by a qualified surveyor and if the value
of a property has appreciated, this can be shown on the Balance Sheet. The increase in value
will be shown on the liability side as a revaluation reserve.

• Plant and Equipment – the machinery required in the manufacturing processes.

Is the amount shown a true reflection of the asset’s realisable value? In a liquidation the
asset may have very little value.
Are the assets adequately insured?
Is depreciation adequate?

• Fixtures, Fittings and Motor Vehicles – may be shown separately where substantial. Check
that depreciation is adequate.

■ Intangible Assets

• Goodwill – this only arises on acquisition where a business is acquired for a price greater
than its net asset value. Sometimes goodwill and intangible assets are written off over a
period of years.

• Patents, Licences and Trademarks – these can have substantial value in that they may
result in the accrual of future benefits to the company. They can only be shown on a Balance
Sheet if purchased from or when acquiring another company.
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■ Liabilities
Liabilities indicate amounts owed by the company and claims against the assets of the company.
■ Current Liabilities
Those amounts due to creditors of the company within one year.
■ Short Term Debt
Amounts due such as overdrafts/short term debt. These are facilities that must be repaid on
demand or are committed for less than a year and consequently will be shown as current
liabilities.
■ Long Term Debt
Current – that element of long term debt that is due for repayment within 12 months of the
Balance Sheet date.
■ Dividends Payable
The amount of dividends declared by a company in the P & L statement and not yet distributed.
■ Trade Creditors/Accounts Payable/Bills Payable
The free credit granted of suppliers of goods and services required by the company’s trading
activities. It is important to know whether these creditors hold security either over goods
supplied or other assets of the company. Are creditors well spread? Can creditors be paid as they
fall due? Compare with Debtors. If there are no cash transactions, debtors should exceed creditors.
What proportion of creditors are Pay As You Earn/National Insurance/Value Added Tax?
HM Revenue and Customs are Preferential Creditors.
Can an aged analysis of creditors be provided?
■ Sundry Taxes Payable
Other taxes than that charged on the profit of the company.
■ Other Creditors
Those to whom money is owed in the next 12 months other than creditors already specified.
■ Accruals
Those liabilities that correspond to and have arisen within the last financial period but have
not yet been invoiced.
■ Corporation Tax Payable
The amount of tax payable on profits within the following 12 months.
■ Due to Group Companies
May be included in general creditor figure but should be noted separately. In addition, even
where it is stated as long term many consider it a current liability; in the event of difficulties
this amount may well be paid off prior to due date.
■ Due to Directors
May appear in the accounts of smaller companies, either in the form of loans or undrawn
remuneration; also often considered as current for similar reasons. If the directors have no
intention of withdrawing these monies, it is possible to look on these sums as quasi capital. If
needs be, a letter of postponement of the repayment of the loan monies may be completed.
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■ Long Term Liabilities

Those liabilities due in a period of over one year.
■ Shareholders’ Funds/Net Worth/Equity
Equity represents the owners’ share in the assets of the business and equates to the difference
between total assets and total liabilities due to outsiders. Any surplus belongs to the proprietors
of the business. Liabilities can generally be defined accurately but the valuation of assets
requires careful analysis to determine the shareholders’ actual equity.
■ Shares
Shares are generally referred to as “risk capital” as the shareholders are the last to be repaid
should the company fail. However, a company may have many different classes of shares,
which will confer different rights to their owners and consequently to which different degrees
of risk apply. Distribution of profits to shareholders may be made out after tax profits by way
of dividend. The most common forms of shares are:
• Ordinary Shares (common stock) – ordinary shareholders usually represent the greater
proportion of shareholders in a company. Within a company’s Balance Sheet the figure for
ordinary shares will represent the nominal value of shares issued to ordinary shareholders.
• Preferred Shares – these confer some preferential rights above those applying to ordinary
shares, the most common being the right to a fixed rate of dividend provided a dividend is
declared and the right to be paid before ordinary shareholders in the event of liquidation.
• Share Premium Account – this arises when shares have been issued at greater (a premium)
to par value and is the most amount of that premium.
• Revaluation Reserves – arises where properties or other assets have been revalued. Not
available for distribution by way of dividends.
■ Retained Earnings
The profit earned as shown in the P & L of a business after payment of dividends and
accumulated since the inception of the company. The total shares and reserves represent the
shareholders’ equity or net worth of the company.
■ Contingent Liabilities
These are potential liabilities which may become due at some future time. Because of their
nature no provision is made in the company’s accounts, but an indication of their extent should
normally be found in the notes to the accounts. Contingent liabilities include guarantees given,
letters of credit opened, bills of exchange discounted. These items should be analysed carefully
as they may have significant impact on the company should they cease to be contingent and
become actual liabilities.
■ Capital Commitments
These represent items of future expenditure and are consequently also off Balance Sheet but
shown as a note to the Balance Sheet as:
• Contracted: where the company is legally committed to purchase an item.
• Authorised but not contracted: where the company has resolved to purchase an item, but
has not as yet legally committed itself by entering into a contract.
■ Lease Obligations
Most accounting standards call for a reasonable amount of information to be provided but
sometimes only current payments will be disclosed. In such cases some attempt should be
made to discover future payments due and the length of the obligation.
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Analysing the information

What we can get from audited accounts

• Trend of Sales
• Trend of Profits
• Trend of Liquidity and Working Capital
• Trend of Net Worth
• Trend of Cost of Sales and Expenses
• Trend of various key ratios
• Customer’s stake in the business
• Gearing
• Composition of Assets, which are indicative of the quality of Working Capital and Net
Worth
• Extent of Directors’ Drawings
• Amount of the company’s deferred taxation liability
• Proportion of Long Term Debt
• Repayment Dates of Loans
• Sources of Finance
• Uses to which finance and earnings have been put
• Revaluation of Assets; Acquisitions and Sales of Assets
• Extent to which expenditure on Intangibles has been capitalised
• Existence of Free Reserves available for distribution
• Deficiencies as revealed by Auditor’s Report – read the Report carefully
• Existence of an Acceptance Credit Facility
• Evidence of potential foreign exchange risk
• Contingent Liabilities
• Name(s) of Subsidiary Company/ies
• Name of Holding Company
• Capital Expenditure Commitments
• Method of valuing Stock and Long Term Contracts
• Depreciation Policy
• Gross Margins and Net Profit
• Relative proportions of Fixed and Variable Expenses
• Bad debts incurred and/or provided for
• Interest on loans, bank loans and overdrafts
• Investment income
• Rent received from property lettings
• Hire purchase interest
• Leasing payments, indicating existence of assets not shown on Balance Sheet
• Non-recurring or extraordinary items of revenue or expenditure
• Prior year adjustments
• Dividend policy
• Changes in capital structure

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What audited accounts do not tell us

Inflation
The effects of inflation on reported accounts are as yet, not reflected in the vast majority of
audited accounts.

Activities
The precise nature of the company’s activities and proportion of turnover derived from
each.

Environment
Government, fiscal, environmental, economic and social factors affecting company.

Market
• Location, area, proportion of turnover in each area
• Number of customers, consumer or commercial, potential customer’s accessibility
• Market share, competitors, number and their market share
• Dependence on one or a few large customers
• Export markets – current and potential
• Dependence on special contracts
• Seasonal fluctuations
• Is market static, growing or declining in volume terms?

Products
• Proportion of business confined to established products
• Dependence on new, as yet untested products
• Are they protected by patents? For how long?
• Volume of each type of product sold (product mix), contribution from each (gross margin
of each)
• Are units high value/low value, heavy/light, big/small and what are implications for
transport?
• Have products a foreseeable demand pattern?
• Is demand elastic or inelastic?
• What are the likely product lives?
• Are replacement products under development?

Management
• Quality of management – integrity, acumen, technical expertise
• One person rule, non-participating board, depth, unbalanced top team
• Age, health and succession
• Other commitments, business connections

Management Information
• What is produced for the benefit of management, such as budgets, cashflow forecasts,
periodic profit and loss reports, debtor ageing analysis, sales?
• Quality of information available from the bookkeeping system?
• What systems are in efficient operation in the company, such as costing, stock control,
labour productivity control, purchasing, production, credit control, etc?

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Labour
• Quality and number skilled/unskilled
• Turnover, absenteeism, availability in the area
• Relations between management and unions
Fixed Assets
• Assets written off which are still, or may become, valuable hidden reserves
• Premises and plant held on lease
• Condition of premises, adequacy for current expansion, location, access, size and value
• Existence of premises used by company
• Whether building specialised and therefore needing to be depreciated
• Premises: whether planning permission for current use held
• Plant: whether modern and competitive, current value, replacement cost, whether
adequately depreciated, condition, whether regularly maintained, capacity, extent to
which capacity utilised needs and planned owned by director
Contingent Liabilities
• Guarantee liabilities, warranties
• Purchase and construction commitments
• Law suits pending against company
• Subsidiary indebtedness
• Exchange risk
• Liability for rentals under leasing agreement
Intangible Assets
• Goodwill, patents, trade marks, etc
Sales
• Volume as opposed to sterling value
• Discount policy
• How much of sales total relates to duty (such as tobacco) thereby distorting apparent
gross margin
Cash
• How typical is cash figure of normal day-to-day balance?
• How much cash is actually available to meet liabilities and how much is permanent float in
cash registers in retail outlets?
Debtors
• Spread of debtors, ageing
• Do company factor debtors?
• Export debtors, method of settlement, proportion due from high-risk countries
• Proportion of trade debtors, retentions, prepayments
• Credit terms offered by company
Creditors
• Spread of creditors, ageing
• Credit terms allowed under pressure from creditors
• Proportion of expense creditors, trade creditors, VAT, PAYE
• Amount of preferential creditors

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Stock
• Proportion of raw materials, work-in-progress, finished goods, etc analysis, etc
• Detailed analysis of types of product and stockturn of each type
• Obsolescence
• Amount of overheads included in valuation
• Whether stock supplied subject to reservation of title clause
• Whether levels are matched to production needs
• Level of shrinkage

Subsidiaries
• Extent of company’s interest in subsidiaries
• Do subsidiaries have different year-end from parent?

Distribution
• Number and location of warehouses, retail outlets, agents, methods of distribution

Insurance
• What insurance cover does company have, such as buildings, fixtures and fittings, plant
and machinery, loss of profits, consequential loss, employer’s liability, public liability,
key-person?

Other
• What are the company’s corporate strategy and objectives?
• Amount of overdraft facilities, acceptance credit facilities, etc
• Availability of raw materials, dependence on one supplier
• Timing and amount of cash requirements of customers, length of order book
• Pricing policy
• Method used in appraising capital investment projects
• Imminent change in technology

Balance Sheets – creative accounting (“window dressing”)

We often say that a Balance Sheet is a snapshot, a moment in time in the company’s life, but we should
also remember that the Balance Sheet may be “window dressed” for the occasion. Some of the ways
in which accounts may be manipulated – some ingenious, some fraudulent – are given below.

■ Debtors

Fail to disclose those debts which are long overdue and almost certainly bad.

■ Stock and WIP

In very many cases these are shown at directors’ valuation and accepted by the auditor without
verification. Following the introduction of Stock Appreciation relief, conservative values
cannot therefore be assumed.

Fail to disclose the slow moving/obsolete lines of stock.

Change the basis of valuing stock and take the surplus into normal trading profit rather than
disclose as an “extraordinary” item.
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■ Fixed Assets

Revalue fixed assets without noting the contingent liability for capital gains tax which may arise.
Surplus/deficit on asset sales may be shown as an adjustment to depreciation, a separate
disclosure or a direct transfer to or from reserves.

■ Maintenance

Cut expenditure on routine maintenance until plant is in such poor condition that it must be
replaced. This can then be treated as Capital Expenditure and attract investment relief.

■ Revenue Expenditure

Capitalise such expenditure as research and development or advertising and write off over a
number of years.

■ Investment Grants

Credit them in full in year of receipt and not over the useful life of the asset.

■ Subsidiaries

Avoid consolidating unprofitable offshoots.

Re-classify an associate company as an investment, then its losses need not be disclosed.
Instruct subsidiaries to increase dividend to parent company.
Each year progressively bring in more results from subsidiaries to the consolidated accounts –
first subsidiaries 100% owned, then 75% owned, then 50% owned.
Run part of your business in the form of a partnership; there is then no need to reveal any
information other than share of partnership profits in “parent” accounts.

■ Gearing

Use leasing to improve the apparent gearing.

■ Directors’ Loans

Inject money on the final day of the financial year and withdraw on the first day of the next
year. Most people will assume it has been there all year round.

■ Sales

Fail to record some cash transactions.

Carry forward sales invoices into the next accounting period (thereby depressing profit) or
bring them back from a subsequent period into the current year (thereby inflating profit).

Include unenforceable sales agreements or goods on sale or return basis.

■ Ratio Juggling

Take in short term funds overnight to improve liquidity at balance sheet date.
Liquidate stock a few days before the year end to improve stockturn.
Squeeze debtors and delay paying creditors immediately prior to year end to improve liquidity.
Delay purchases and speed up submission of invoices prior to the year end.
Using the above methods, working capital and quick asset (acid test) positions can be
manipulated.
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Glossary of frequently used terminology

Accrual accounting The reporting of income and expense at the time they are earned or
incurred, not when they are received or paid.

Asset Item of value, which is owned by a company or person and is

expected to be of economic benefit. Assets may be divided into fixed
assets (such as buildings), current assets (such as stock) or intangible
assets (such as patents).

Balance sheet Periodic (usually annual) statement of a company’s financial

position, which summarises what is owned (assets) and owed
(liabilities) by the business.

Capital Money invested in a business by its owners in order to earn income.

Cash flow The inflow and outflow of cash through a business.

Cash flow forecast Estimation of expected cash flow used to alert management to future
cash shortages or surpluses.

Corporate strategy Assessment of the relationship between an organisation and its

environment, resulting in a plan to achieve the business objectives.

Current assets Assets of a company, which are likely to be converted into cash (such
as debtors, work in progress) within 12 months.

Depreciation The amount by which a fixed asset is diminished in a particular year

through its use in the business. This amount is charged against profits.

Equity The capital invested in a company by its owners, together with profits
from previous years that have not been distributed as dividend.

Fixed assets The assets of a company (such as equipment, land and plant) which
are held not for conversion into cash, but over long periods to further
the main trading activities.

Fixed costs Costs which are unaffected by changes in volume, but tend to change
over time (such as rent, rates).

Gearing Relationship between the amounts invested in a business by its

owners (equity) and by outsiders (debt).

Indirect cost (or overhead) Cost not directly associated with a unit of production and which
will be apportioned across a number of activities or products (such
as the cost of running a canteen in a factory).

Intangible assets Assets which are neither physical nor financial (such as goodwill,
trademarks, licences, etc).

Inventory List detailing stock that is kept for use as required, particularly raw
materials, work in progress, supplies and finished goods.

Liability Obligation of a company to make payment in the foreseeable future

for goods or services already received.

Limited company Company in which the shareholders’ liability is limited by shares or

guarantee.

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Liquidity The pool of accessible funds, either in cash or in assets that may be
transformed rapidly into cash, to meet immediate debts.

Long term debt Loan repayable one year or more from date of transaction.

Net realisable value The price at which assets could be sold minus all the cost of selling
them.

Overtrading Trading which exceeds the financial capacity of a business and may
lead the company into financial distress.

Payback period Time taken for the initial investment in an asset or project to be
repaid from profits.

Preference shares Form of share capital whereby the holders have a preferential right
to receive a dividend out of profits of a certain percentage of the
share capital before the owners of ordinary shares get any dividend.

Price earnings ratio (PE) The relationship that a company’s profits bear to the publicly quoted
value of its shares, usually expressed as market value of share/
earnings per share.

Profit What remains when costs (of producing, selling etc) have been
deducted from revenues.

Sale and leaseback Form of financing by which a business sells an asset, which it owns
and then leases it back at an annual rent from the purchaser.

Share capital The amount of money invested in a company by its risk-taking

shareholders.

Share premium Money received by a company for a share issue which is in excess of
its nominal value.

Solvency Maintenance of a sufficient level of liquid assets by a company to

meet its short term obligations.

Statement of Source and Analysis of the sources of funds (financial resources) and how they
Application of Funds (SSAF) have been used, showing how and why a company’s cash position
has changed.

SWOT Acronym for strengths, weaknesses, opportunities and threats

relating to a company. These are investigated as part of strategic
analysis.

Turnover The gross revenue earned from providing goods/services to

customers.

Variable costs Costs that vary directly with the level of output.

Working capital The amount of short term funds available to a business to perform
its normal trading operations. Usually defined as the difference
between current assets and current liabilities.

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Lending Techniques

Review

The main points introduced here are:

■ Always try to obtain the relative financial information before meeting the
customer so that you can prepare the questions you intend to ask.

■ Seek confirmation and clarification of the customer’s statements.

■ It is the customer’s responsibility to provide all the relative information you

require.

■ Be sure that you fully understand the risk involved with the proposition before
drawing a conclusion and stating your decision.

■ The lending decision will be based on an appraisal of the financial and non-
financial information that the customer provides.

■ A business plan should cover: objectives, the business, management, market,

products/services, pricing, suppliers, physical resources, people resources, profit
and cash forecasts, outside finance required.

■ Mnemonics can be helpful in a lending appraisal, such as CCCPARTS, PEST,

PARSER, CAMPARI.

■ Key assessment areas are: the customer and the business, asset cover, repayment
ability/serviceability of debt, monitoring of performance.

■ Analysis of the business’s financial performance is the major factor in the lending
assessment, including examining the customer’s existing bank record and
incorporating detailed analysis of the audited accounts.

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Credit Skills Library

This is one in a series of topics about credit, designed for easy access
by banking professionals with a special interest in this field

Further information on the Credit Skills Library:

www.charteredbanker.com

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